Analysis of developments in financial markets, economics and public policy geared towards anyone with a stake in these issues......and, yes, we all have one.

Friday, October 19, 2012

Financial Repression Is Not Foregoing The Purchase Of A New Audi.

Or that of a 60-inch
plasma TV, a Prada handbag, or in my case, a slick new carbon fiber bicycle. Instead,
it is an unwritten policy aimed at relieving high levels of government debt by
rigging interest rates in a manner that favors profligate spenders (i.e. said
governments) at the expense of savers. It is akin to Quantitative Easing (QE), another
formerly obscure economic concept that has recently made its way from
theoretical discussion to widespread application across advanced economies. For
those just tuning in, QE is the policy (this time overt) undertaken by the
Federal Reserve, among others, purportedly aimed at kick-starting economic
growth. But while the second word of QE rolls smoothly off the tongue,
suggesting a benign nature, Financial Repression
conjures up a more ominous sensation, one often associated with the works of a particular
Austrian psychoanalyst; an act that inevitably comes back to haunt the
practitioner in deleterious ways. While QE gets top billing, one can argue that
it is but a tool utilized to accomplish the ends set forth by Financial Repression.

In practice
Financial Repression has been around at least since the aftermath of WWII, as
advanced economies sought to dig out from mountains of debt built up during the
war effort. The term was coined by academics in the 1970s and has recently been
employed by economists Carmen Reinhart and Belen Sbrancia in calling out
indebted governments for reinstituting the practice. Just as with QE, what
seems obscure at first actually affects us all in its impact on economic growth
and investment returns, especially concerning the aforementioned punishment meted
out on savers. Financial Repression also puts at risk the decades-long strides in
globalization and the liberalization of capital markets. Perhaps most importantly,
it exposes a fundamental flaw in financial systems where the top cops (the
regulators) are also the biggest borrowers (governments).

What Is It and Do I Need to See a Shrink?

No
psychologist is necessary, although you may become depressed when visiting loan
officers or opening investment statements during periods of Financial Repression.
As for a barebones definition: Financial Repression is the act of governments
using a suite of tools to force down nominal interest rates and cajole
investors into favoring government debt. The former technique lowers the
interest payments of outstanding government liabilities, while the latter creates
demand for sovereigns at levels likely higher than what would occur in truly
free markets. These steps are rendered more effective if accompanied by a bout
of inflation (a stated aim of QE….how convenient). The combination of low
nominal rates and elevated inflation create a climate of low….possibly negative….real
interest rates. Negative real interest rates are tonic for free-wheeling
government spenders as they magically cause their liabilities to shrink. What is
the secret of this elixir? If a borrower’s interest rate is below the rate of
inflation, the value of future payments is reduced, thus easing the debt
burden.

On the
flipside, the payments going to lenders in a negative real rate environment are
diminished, leaving them with less than what they anticipated receiving. More
broadly such an environment means that any money kept in investment or savings
accounts would be at risk of losing value (inflation is the arch-nemesis of
fixed-income investors). This creates a disincentive to save and lend, which
tosses a soggy towel on economic growth, especially in a leverage-dependent
economy such as the United States. Reinhart and Sbrancia show that for much of
the three decades in the aftermath of WWII, real rates in advanced economies
were often negative. During the more liberalized years beginning in the 1980s,
real yields were negative less than 15% of the time. This period was accompanied
by impressive U.S. economic growth. Since the onset of the financial crisis,
real rates have been negative half the time and less than 1% for over 80% of
the period. And we wonder why banks won’t lend.

A Tax By Any Other Name….

Aside from
the obvious benefit of monetizing one’s debt away, policy makers….being cowards…have
an added motivation for pursuing a policy of Financial Repression. In order to
improve a nation’s perilous fiscal position, authorities can opt for a
multitude of policies. Ideally pro-growth initiatives can be implemented and the
ensuing reinvigorated economy not only moderates the debt/GDP burden by expanding
the denominator in the equation, it also raises government revenues, which
serve to balance the budget and thus not add to existing debt. Things get
trickier in low-growth environments, such as those found in post housing-boom
America and shipwrecked Europe. To quote Reinhart and Sbrancia, “given that deficit reduction usually
involves highly unpopular expenditure reductions and/or tax increases,
authorities…..may find the stealthier financial repression tax politically
palatable.” But at the end of the day, a tax is what it is: one that
extracts money from the broader economy to pay for government’s past fiscal
sins. What’s more, studies have shown that strict austerity measures have a
larger negative impact on growth than previously estimated (just look at Spain),
which only makes Financial Repression all the more tempting.

Crossing the Rubicon

Policy makers
have plenty of tools at their disposal to execute this scheme. Most famously is
the Fed Funds rate, which will continue to be stapled to the floor through at
least mid-2015. This key rate serves as an anchor for yields on shorter
maturity instruments such as T-Bills and Notes. Next up are the three iterations
of QE, in which the Fed created funds (i.e. printed money) to purchase Treasuries.
Original purchases were aimed at the so-called belly of the yield curve (3-5
year maturities), but since that did absolutely nothing for economic growth,
they came up with Operation Twist, which concentrates on longer-dated
securities in hopes of catalyzing a still stagnant housing market….like anyone
can qualify for a loan.

QE has seen
the Fed become the predominant buyer of new-issued Treasuries. Data show that Treasuries
held by the official sector, that is the
Fed along with foreign central banks (more on that later), now approaches 50%,
the highest level in decades. As most observers are aware, the purpose of
having an independent central bank is to separate monetary policy from fiscal
policy. With the Fed presently scooping of so much government debt, it is safe
to say that that line has been crossed.

From 1996 to
2007, the Treasury issued on average $592 billion in debt annually. In the ensuing
four years, that figure rocketed to $1.88 trillion. Driving the increase are
trillion dollar deficits as government revenue waned during the recession and
automatic stabilizers…along with other spending…..ramped up. As seen in the
second chart, that tsunami of supply was eagerly met with corresponding demand….from
the Fed.

Stacking the Deck

In addition
to central bank purchases, Treasury officials want to goose demand for their securities
from other market players. This is accomplished through regulations on banking
capital. During the financial crisis, banks on both sides of the Atlantic were
famously undercapitalized, which meant they were levered to their eyelids.
Regulators have since demanded that banks keep adequate capital on their books
to absorb losses before depositors potentially get wiped out (a key rationale
for bank regulation in the first place). Under the umbrella of Basel III, an
initiative by the Bank of International Settlements and with which the
gargantuan Dodd-Frank law is in compliance, over the next few years, banks will
increase this capital cushion by jacking up the most solid type of capital,
common equity. Without getting too granular, common stock and Tier One capital
will now comprise 4.5% and 6% of risk
weighted assets respectively, the key term being risk weighted assets.

And just what
are these? Bank assets are in the form of loans as well as securities purchased
in financial markets. These instruments have varying risk profiles depending
upon the credit quality of the borrower or issuer. Higher quality assets are
deemed safer and are assigned a discount to the nominal amount. The goal of any
bank is to increase return on equity (ROE), a task made more challenging when forced
to hold more equity. But….and this is where it gets juicy….if the bank holds a
bunch of high quality assets with corresponding discounts in nominal value,
they are can lend more money without bumping up against the capital limits. And
what assets do regulators say are the highest quality? You guessed it: sovereign
debt, issued by the bosses of said regulators. This exemplifies the inherent
conflict interest with governments being among the largest borrowers. For proof
of the frailty of such a system, just look at Spanish, Greek, Portuguese and
Italian banks which loaded up on government securities in the run up to Europe’s
financial crisis. Not only was the debt of overleveraged borrowers (the
sovereigns) mistakenly considered risk free (hah!), but also once the European
Central Bank waived its requirement of accepting only investment-grade
securities as collateral for loans, the region’s banks loaded upon even more on…now
junk-rated…government debt in order to send to the ECB in return for the daily
funding needed to keep these institutions alive. To a lesser degree, the same
house of cards is being constructed in both the U.K. and United States. Further
demand for government debt is engineered by requiring domestic players such as
pension funds to hold a certain level of….ahem….safe domestic debt.

It’s Not
Such A Small World After All.

Some of the
biggest critics of QE are emerging market leaders who posit that yield-seeking
investors are fleeing advanced economies and flooding rapidly developing
countries with unwanted funds. Such an injection of foreign capital can ignite
inflation and spur asset bubbles in stocks and real estate. In an effort to
combat these potentialities, EM central banks have instituted capital controls
(Brazil) and buy up foreign earnings with local currency (China), thus
suppressing its value, which aids exports. Ironically, the dollars purchased by
EM authorities are often recycled back into U.S. Treasuries, aiding the Financial
Repression process. This combination of advanced economies erecting barriers to
keep funds captive (to purchase government debt) and emerging markets trying to
keep funds out is a far cry from the unfettered flow of capital championed by
many of the same authorities over the past few decades. Should such
protectionist measures take root, escalation to an all-out trade war could
follow, which would only create yet another drag on already moderating global
growth.

Some More Unintended Consequences

No entry to
these pages is complete without mentioning the above phrase. But being that no
one within the Beltway is apparently concerned about the knock-off effects of
current monetary/fiscal policy, someone has to be. Yet another goal of QE is to
chase investors into higher yielding assets such as speculative bonds and
equities with the hope that a windfall of funds will cause corporate decision
makers to expand operations. This is putting the cart before the horse being
that supply (corporate activity) is usually in response to increased demand
(which is still tepid…especially from the consumer). It also ignores the fact
that U.S. firms are flush with cash and are simply not deploying it until they see
seeds of sustainable growth. Should younger folks want to take a gamble that
growth is around the corner and valuations are favorable, it could be a great
time to hop back into the market. For older investors seeking a stable yield on
their savings, QE and Financial Repression signify a weakening of their future
buying power. Not only has the market mechanism for interest rates been distorted,
causing less risky assets to throw off paltry yields, but also inflation is
being imported via a weaker dollar, further socking savers in the teeth. Visit
a gas station recently? As stated a touch of inflation is a condition that
enables financial repressors to more rapidly reduce their debt load.

Officials are
quick to castigate banks for not lending. But policies that favor government
debt over that of the private sector deny funds to the productive segment of
the economy. This is especially true for small and mid-sized businesses along
with lower-rated corporates that still face hurdles in obtaining financing.

Governments
want to shrink their debt load, but both austerity measures and Financial Repression
cause drags on the growth needed to help pull the economy towards a sustainable
upward trajectory - the so-called…and elusive…escape velocity. Low rates won’t
last forever, despite the government’s best efforts to keep a lid on them. To
complete the cobweb between monetary and fiscal policy, the Treasury has taken
advantage of suppressed rates by shortening the maturity of outstanding debt.
This takes advantage of the lower rates on shorter-dated Notes. Should rates
normalize before liabilities are moderated…which could be a while given gross
debt is over 100% of GDP….debt servicing expenditure would blow out, which
would undo any of the adjustment already undertaken via Financial Repression. Neither
math, nor time, is on policy makers’ side. In the meantime savers and credit-starved
business owners suffer.

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About Me

During my career as an investment analyst, several developments from the realms of financial markets, economics and public policy struck me as highly relevant, not to me in my role as a market observer, but in my role as a citizen. The subjects covered on these pages are not aimed at fellow investors or policy junkies, but to the broader population, which needs to recognize the shifts occuring in the economy and understand their consequences, as well as those of government policy.